The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, October 24, 2012

Assault on living standards to continue until banks write-off bad debt

In his Telegraph column, Jeremy Warner looks at the assault on living standards that has occurred in the UK since the financial crisis and concludes that it is going to continue until the banks write-off their bad debts.

This assault on living standards is the direct result of the choice by UK policy makers and financial regulators to adopt the Japanese Model for handling a bank solvency led financial crisis and protect bank book capital levels and banker bonuses at all costs.

The cost UK policy makers and financial regulators were and still are willing to pay is to lower the standard of living across the UK.

Your humble blogger has repeatedly said that there is no reason that society should bear this cost. There is an alternative if the policy makers and financial regulators pursue the Swedish Model for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to realize up front the losses they would incur on the excess debt in the financial system if this debt went through the long process of bankruptcy/foreclosure.

By making the banks absorb the losses, the real economy, including the standard of living, is protected.

A modern banking system is designed so that banks can absorb the losses and continue to support the real economy. They have access to deposit guarantees and central bank funding which allows banks to operate even when they have low or negative book capital levels.

Why can banks operate with low or even negative book capital levels? Because with deposit guarantees, the taxpayer effectively becomes their silent equity partner (this is also the reason that countries should never recapitalize their banks).

While the taxpayer is the silent equity partner, banks should be required to retain 100% of pre-banker bonus earnings until such time as the banks have rebuilt their book capital levels.

But recapitalizing the banks through retained earnings could take years!

True. The Institute of International Finance, a bank lobbying firm, showed that Spanish banks could generate enough earnings to recapitalize the banking system in under 5 years.

Your humble blogger thinks protecting society and the standard of living is more important than bankers getting cash bonuses for 5 years. Particularly, when the bankers will get bonuses in stock that they can turn into cash.

Close to the start of the economic crisis, someone I've always considered one of the City's more astute practitioners privately ventured what seemed a somewhat startling prediction – by the time it was all over, average living standards in Britain and many of other advanced economies would have fallen in real terms by 20pc or more.

At the time, I was minded to dismiss the suggestion as unduly alarmist. As the years pass, however, the forecast is if anything beginning to look on the over optimistic side.

Indeed, according to a first attempt by the Office for National Statistics this week to measure "national well being", we are already well on the way, with net national income per head falling by 13.2pc in real terms since the start of the crisis in 2008....

The Governor is still as reluctant as ever to concede the central bank's own culpability in the crisis – no mention of that in this week's speech - but it is hard to disagree with the thrust of his comments – that though the policy response may have smoothed the adjustment, it can't eradicate it, and it may now have reached the limits of its capacity to do even that.

As regular readers will know, I've been progressively more sceptical over the efficacy or appropriateness of further demand management measures to ease the crisis, so I was heartened to hear Sir Mervyn rule out some of the more exotic suggestions for getting the economy going again.....

None of this is to suggest that the authorities are getting their policy response broadly right.

There is obviously something in Sir Mervyn's assertion that the economy cannot truly mend itself until the banks have fully dealt with their bad debts.

But it is a strange old world which sees policy makers such as Sir Mervyn insisting that banks raise more capital to pay for these write-offs in conditions where neither markets nor governments are prepared to provide it.

The critical point that Mr. Warner misses is that in a modern banking system banks do not need to be recapitalized at the same time they recognize their losses. Banks can recognize all their losses today and rebuild their book capital level over years.

This makes further deleveraging more or less inevitable, requiring repeated rounds of central bank money printing to counter it. It's hard to see how central bankers are ever going to get off this treadmill.

By requiring the banks to recognize their losses upfront.

As ever in this crisis, the application of policy seems quite at odds with its goals.

Thus it is that a crisis caused by too much debt is addressed by yet more debt, even though the end objective is presumably to get this debt off our backs.

The policy response has become a terrible muddle, which in its attempt constantly to put off until tomorrow what properly belongs to today brings to mind the concluding line of the Great Gatsby: "So we beat on, boats against the current, borne back ceaselessly into the past".

What a great summary of why the Japanese Model fails. It never addresses the issue and engages in endless round of fiscal and monetary stimulus to try to offset the effect of the burden of the excess debt on the real economy.

My City friend was right, this adjustment is on a very long fuse....

The assault on living standards has a way to run yet.

As Japan has shown, we are talking decades.

However, if policy makers and financial regulators were to adopt the Swedish Model, as Iceland has shown, the economy would rapidly return to its pre-crisis level.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.